Government programs to blunt the economic impact of the coronavirus pandemic will make the federal budget deficit much wider in 2020 than at any point in the last 75 years. The nonpartisan Congressional Budget Office’s new forecasts, released two weeks ago, predict that the deficit will be over $3.3 trillion this year, or 16% of annual economic output. Measured as a share of GDP, the annual U.S. budget deficit hasn’t hit double digits since 1945. The CBO forecasts that the 2021 deficit will be higher than in all but two years between 1946 and 2019.
These deficits will boost the national debt, which the CBO forecasts will total $21.9 trillion in 2021. Next year, for the first time since World War II, the national debt will be larger than annual GDP. Beginning in 2023, the CBO projects that the debt will be larger than at any point in U.S. history.
That’s a problem, but not a reason to panic. Now isn’t the time to reduce the debt, but the bill will eventually have to be paid.
Debt and deficits matter. Some on the political left argue that they don’t, embracing “modern monetary theory” as a permission structure for significant increases in federal spending on the unpersuasive grounds that the federal government can print all the money it needs. Some on the political right argue that deficits matter more than they actually do. It was common to hear conservatives warn that the U.S. was on the brink of a Greek-style debt crisis as a consequence of the borrowing following the 2008 financial crisis and recession. Many Republican senators today oppose an additional economic recovery package because they are excessively concerned about borrowing.
The truth about deficits and debt is in-between. The economic damage they cause is more akin to slow rot in the foundation of a house than a tornado suddenly blowing it down.
Deficits reduce national savings, shrinking the pool of funds available for private-sector investment. Over time, less investment leads to lower productivity and slower wage growth, reducing living standards and economic output. Inflows of foreign capital can make up for this, but also lead to increases in payments to foreign investors and reductions in domestic income. In a 2014 paper, the CBO estimated that a one-dollar increase in the budget deficit reduces national savings by 57 cents and domestic investment by 33 cents. Additional debt increases interest rates. A 2019 CBO working paper found that a one-percentage-point increase in the ratio of debt to annual GDP increases rates by two to three basis points.
In 2020, the government will spend 1.6% of GDP on debt service, or more than double the amount of revenue raised by taxes on corporate income. By 2030, the CBO projects interest payments will be 2.2% of GDP. For context, defense spending as a share of GDP is projected to be 2.9%. As the amount of the federal budget devoted to interest payments increases, other priorities for government spending will be crowded out. Higher levels of debt also raise the risk of a slow erosion of the attractiveness of U.S. debt and currency in international markets and gradual increases in inflation expectations.
But the U.S. still has quite a bit of room to borrow when needed. In the face of rapid increases in the U.S. national debt, investors in global capital markets continue to purchase government bonds, and real interest rates on government debt are continuing a four-decade decline. Inflation has also remained low for the last two decades. This has led me to soften my view on the importance of debt and deficits.
What matters most about the debt is its trajectory, not its level. And that’s where the real problem lies. Prior to the pandemic, the debt was already rising unsustainably. The necessary spending related to the virus has not materially changed the debt’s course because it is temporary.
The gap between tax revenue and projected spending for Social Security and Medicare — which itself is driven by an aging population and the rising cost of health care — is the cause of the U.S. debt problem. The CBO released long-term budget projections in January, before pandemic-related spending had occurred. As a share of GDP, Social Security spending was projected to increase by 29% between 2020 and 2040. Medicare spending was projected to increase by 73% over the same period. Apart from other health programs and interest payments, all other spending was projected to decline, while the ratio of debt to GDP was expected to rise from 81% to 130%.
To address this, Congress should gradually make Social Security and Medicare less generous, giving many years of prior notice so households can make long-term plans. Spending cuts should constitute the lion’s share of Congress’s solution to the debt problem, but they should be combined with increases in revenue from taxing pollution or consumption. The goal shouldn’t be to slash the debt over a period of just a few years, but instead to put the ratio of debt to GDP on a downward trajectory.
Debt and deficits matter, but they are not all that matters. This year’s enormous deficit was justified. The economic emergency facing the U.S. requires additional deficit-financed spending, as well. But borrowing isn’t without cost. To make sure the U.S. can meet future challenges when deficit spending is called for, putting the national debt on a downward trajectory should be a top priority for the next Congress.
Michael R. Strain is a Bloomberg Opinion columnist. He is director of economic policy studies and Arthur F. Burns Scholar in Political Economy at the American Enterprise Institute. He is the author of “The American Dream Is Not Dead: (But Populism Could Kill It).”